Commodity ETFs do not seem to be widely used in investor portfolios. As a whole, these ETFs hold about $137 billion. This is just 2% of the $6.7 trillion in all U.S.-listed ETFs. Yet the asset class has many benefits for those who allocate to this space.
With a return stream that has relatively low correlation to both equities and fixed income, commodities offer diversification benefits to a portfolio.
This is more relevant than ever in the current market environment, in which equities and fixed income are experiencing a period of negative returns.
Over the trailing month, the SPDR S&P 500 ETF Trust (SPY) has dropped by 4.8%. Fixed income has also been hurt by a steepening yield curve, with the iShares Core U.S. Aggregate Bond ETF (AGG) falling by 1.1% over the same time frame.
The Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC) has fared much better over the trailing month, gaining 4.7%. This actively managed ETF holds a diverse basket of commodity futures and is the largest broad-based commodity ETF at this time, holding $6 billion in assets.
Trailing 1-Month Performance
Diversification, Not Outperformance
Of course, investment portfolio decisions should not be based on short-term performance. And looking at the longer-term performance of PDBC relative to SPY or AGG since inception does not tell quite the same story.
What Falls Bounces Back
After commodities tumbled in 2015, the broad-based commodity ETF has not been able to recover from these early losses. PDBC remains down by 5.3% since its launch, underperforming both AGG and SPY.
The lengthy period of underperformance could be a hint that the space is overdue for outsized returns. Commodities might still have room to run in the rally that’s been in place since last spring.
And while there is some correlation between the returns of PDBC and SPY, such as the drawdown experienced by both ETFs in February and March 2020, the two funds are not always moving in tandem or to the same degree.
One reason that commodities offer such diversification benefits is that the asset class itself is diversified. The benchmark tracked by PDBC and other broad-based commodity ETFs includes exposure to a variety of different commodities. These include energy, precious metals, industrial metals and agriculture sectors.
Each of these different commodities is affected by different factors. The Invesco DB Agriculture Fund (DBA) might be affected by unexpected weather patterns, while an oil fund like the United States Oil Fund LP (USO) might fluctuate on the outcome of OPEC decisions or even market distortions caused by the pandemic. (Read: USO Facing Regulatory Action)
Just as with everything else, supply and demand underpin the price fluctuations of various commodities. But the sources of supply and demand are different for each type.
Some commodities, like corn or oil, have more practical use, driving demand. Others such as gold see demand due to their perception as a store of value. Investors tend to flock to gold ETFs in risk-off environments.
The two largest commodity ETFs are gold-specific. The SPDR Gold Trust (GLD) holds over 40% of all commodity ETF assets, standing at $56 billion. The iShares Gold Trust (IAU), which launched a year after GLD, has half of that, having gathered $28 billion.
Commodities can also be an effective way to hedge against inflation risk, a concern that’s currently at the forefront of many investors’ minds. CPI breached the 5.0% level this year, reaching a 5.4% annual increase in prices in June and July. The last time CPI increased at this rate was in July and August of 2008.
During this time period, the Invesco DB Commodity Index Tracking Fund (DBC) performed very well relative to SPY and AGG, gaining nearly 20% in the first eight months of the year.
Since commodities are inputs into many of the goods we consume in our day-to-day lives, the asset class is an important driver of this inflation. It is the rising costs of these goods that often leads to the inflationary pressures in the economy. This relationship is what makes them an effective hedge.
Inflation is a negative on the real value of bonds due to their fixed-coupon payments. And while a small amount of inflation can be a positive for stocks, an unexpected increase in the level of inflation is likely to have a negative effect, particularly on growth and tech names. (Read: Shifting Yield Curve Impacts ETFs)
With Federal Reserve Chair Jerome Powell recently warning Congress that inflation pressures could last longer than expected due to supply chain issues, commodities could be an asset class worth having in your portfolio to hedge against this specific type of risk.